From the February 2017 issue of Investment Advisor • Subscribe!

ETFs and the ESG Investor

ETFs lead the industry in innovation; can they bring that innovation to the ESG space?

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There are three main areas for ETF growth in impact investing. There are three main areas for ETF growth in impact investing.

The rollout of innovative investment strategies continues to stand out as one of the many great attributes of the ETF industry. From asset allocation, and fundamental, technical and tactical index weightings to 21st-century themes that include cybersecurity and social media, ETFs are leading the asset management industry in innovation while responding to investor demands.

Environmental, social and governance (ESG) investing — also referred to as socially responsible investing (SRI) or impact investing — is one such area that has garnered a good deal of focus, particularly for its placement among various indexes. A flurry of index development announcements and ETF product registrations have targeted various asset classes and investment strategies with an ESG filter. From my own experiences developing one of the first actively managed impact investing ETFs (in conjunction with Philippe Cousteau, Jr. and the GlobalECHO Foundation), I know ETF providers and investors will discover a challenge as they shift from an environment where stocks can be sliced and diced in so many quantitative ways to a thoughtful forum populated with differing views and opinions on what qualifies as ESG.

(Related: Sustainable and Impact Investing in U.S. Surges by 33%: Report)

Some cynics have opined that they do not view the world's largest producer of smartphones and tablets as an ESG company due to the paper and plastics used to package its most popular products. However, a strong contingent of sustainable advocates believes that the company's focus on renewable energy use in the United States, its recycling programs and carbon credits qualifies it as being very “E” as it relates to ESG.

Other detractors argue that overseas labor issues with contractors may trigger a lower score in the “S” department, but that can be countered with its industry-leading employment equality policies in the U.S. A firm's ESG qualifications ultimately boil down to one individual's standards versus another's.

Hurdles for Impact ETFs

The concern for ETF investors, despite the industry's gravitational pull towards innovation, is that ESG will not be an area that is well-served by financial products, including ETFs. However, if millennial investors represent a fresh wave of sustainability advocates and impact investors, as is often suggested by financial media, then significant opportunities still exist. A retiring baby boomer population could also deliver a large amount of capital that brings a sharper focus on leaving a lasting legacy, although alternative avenues exist to do so beyond an ESG approach.

Current industry trends and investor sentiment suggest that impact investing success in the ETF space will likely occur in three areas: with established ESG managers whose approach aligns with investors’ preferential view of the ESG space; in more granular approaches, where in general, ETFs have a successful history (ETFs that carry out a carbon-free mandate or invest in companies with female CEOs are good examples of targeting a specific ESG theme that proves much easier to define and resonate with investors.); and to market investment strategies that support charitable, philanthropic or impact activities where a portion of the fund's assets make direct contributions to causes deemed important by the investor.

The prevailing strategy will probably be a combination of different approaches — using investor capital to support public equities and debts of organizations that are important to investors’ beliefs, as well as reallocating portions of profits to philanthropically support initiatives that fuel investors’ passions.

While the industry may witness the launchings and closings of many ETFs, the ESG sector remains opportunistic for your clients and their interests. The intersection of socially conscious investing and charitable endeavors will not only make a positive impact on the asset management industry and advisors, but most importantly on your clients and the world. ETFs represent just the vehicles for such a ride.

--- Read 5 ‘Irrefutable’ Trends That Will Increase Advisors’ ETF Use on ThinkAdvisor. 

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